Great stocks share three winning traits:
- They're self-funded. Top stocks produce bushels of free cash flow. Cisco (Nasdaq: CSCO ) and eBay (Nasdaq: EBAY ) are perfect examples of this. Combined, they've produced nearly $12 billion in FCF over the past 12 months alone.
- They grow fast. Big winners tend to attract customers and produce massive revenue growth, as Intuitive Surgical (Nasdaq: ISRG ) has over the past five years.
- They possess sustainable advantages. Great stocks have the chops to fund growth and expand margins. Think of IBM (NYSE: IBM ) and its unrivaled research and development arm. Or Coca-Cola and its planetwide brand recognition.
Every one of these companies is a great business. I highlight them here because history proves that, while low-priced businesses can make for good returns, reasonably priced great businesses can make you rich.
Cheap stocks, cheap returns
Consider Google. When the search king was preparing for its August 2004 IPO, hundreds of stocks sold for less than 15 times earnings. Why pick 15? Jeremy Siegel pegs the 130-year average P/E of the market at 14.45.
Google, selling for around 100 times earnings, wasn't anywhere near that. Investors adhering to the investapo's party line -- that pricey multiples are rarely rewarded -- opted out of Google and into "cheap" stocks. JPMorgan Chase (NYSE: JPM ) and Freddie Mac (NYSE: FRE ) , for example, which were trading for 11.1 and 10.2 times earnings, respectively, on the day of DoubleGoo's public debut.
But it was the cheapskates who went unrewarded. JPMorgan Chase and Freddie Mac have badly lagged Google and the market since the summer of 2004.
Great businesses, great returns
If you were to check my portfolio today you'd see that I'm one of many who didn't cash in on Google. But you'd also see that I'm following the strategy outlined here: I own great businesses.
My fervent belief is that by concentrating my resources in the very best businesses -- the ones that are self-funded, growing fast, and feature sustainable advantages -- I'll reap millions.
And I do mean "concentrate." One of my holdings accounts for a full 17% of my portfolio. It's the best stock idea I've ever seen:
- Free cash flow exceeded $100 million last year.
- Revenue is up more than 20% over the same period.
- Operating margins are expanding dramatically, and net margin is up over 25%.
What really excites me, though, is that this stock, which commands just $2 billion in market value, is about to enter a hypergrowth phase that could unleash tens of billions in additional value.
David Gardner agrees. He names this stock, which was first recommended in the July 2002 issue, as one of his five best buys right now in Motley Fool Stock Advisor. You can find out why with a 30-day free trial to the service. You'll get unfettered access to all of David's picks, and there's no obligation to subscribe.
This article was first published Feb. 27, 2008. It has been updated.
Fool contributor Tim Beyers owned shares of IBM at the time of publication. Intuitive Surgical is a Rule Breakers recommendation. Coca-Cola is an Inside Value pick. JPMorgan Chase is an Income Investor recommendation. eBay is a Stock Advisor selection. The Motley Fool's disclosure policy would be the best-dressed disclosure policy if words didn't already prefer to be naked.